The Next Crisis Won’t Start with Mortgages. The Spark is Bank Debt.

All financial crises are the same and different at the same time. They are the same when it comes to the dynamics of contagion, illiquidity, bank failures and the high-panic state in which everyone in the world wants his money back at the same time. Yet, each crisis is different in its specific causes.

The 1994 Tequila Crisis was caused by Mexico’s inability to rollover short-term unsecured debts. The 1998 Russia-LTCM crisis started in 1997 with Thailand devaluing its currency. That panic spread around the world through Indonesia, South Korea, Malaysia and Russia before finally landing in Greenwich, Connecticut, home of Long-Term Capital Management.

Wall Street, and Lehman Brothers in particular, would have been the next victims if LTCM had not been rescued by the same banks with the most to lose. Of course, the 2008 panic had its roots in sub-prime mortgages, but quickly spread to debt obligations of all kinds especially money market funds and European bank commercial paper.

According to thisarticle,the next crisis will begin in the private bank debt market. The specific culprit is a kind of debt called “contingent convertible” debt or CoCos. These bonds start out like ordinary debt, but a bank in distress could convert them to equity to improve its capital ratios.

The problem is that bondholders know this and start dumping the bonds before the bank can pull the trigger on the conversion clause. This can cause a run on the bank and trigger cross default clauses in other bonds. Far from adding safety to bank capital structures, CoCos can make banks more unstable by igniting panics.

This is just one more example of capital market complexity and it signals the fact that the next crisis will be worse than the last.